Client Letter, October 8, 2018
Quick Summary: The end of an era may be at hand. The rally in bond prices that dates back to 1981 appears to be over. I’m not convinced it’s over for good but that’s an argument to be made later on.
In the meantime, falling bond prices represent a headwind for stocks and could remain so until bond prices find a short term floor. This headwind accelerated the decline in stocks on October 4th and 5th. This prompted me to raise cash from holdings that either had losses or were laggard holdings. A portion of cash was used to purchase hedges to oﬀset any future stock price declines.
It’s most likely that this is just a short or intermediate termed decline in stocks as the long term trend remains firmly in place. Part of the purpose of quick market declines is to make investors fearful and uneasy, one reason we use hedges to cushion declines.
Chart 1: This chart below shows that the long term trend to lower interest rates is being threatened. This can’t be a surprise with the rapidly expanding deficits and very low unemployment. But as I’ve highlighted with arrows: it’s not uncommon for interest rates to rise in the latter stages of the business cycle, only to fall hard when the Fed raises rates enough to trigger recession. I don’t see this time as any different. My best guess is the current bond weakness is a future buying opportunity later in 2019.
Chart 2: Proxy for the 30-Year T-bond is the TLT. The chart below is inverse to Chart 1 above. Any further weakness with a close below $113 could accelerate the bond sell-oﬀ which would trigger more stock market weakness in the short term.
Chart 3: A direct beneficiary of the decline in bond prices is setting itself up for a very good risk/reward trade. As the bond market declines, the TBT will rally higher.
Chart 4: Internal market strength was showing an important discrepancy with the Advance/Decline line which did not confirm the most recent market peak as it should. This non-confirmation gives us a clue that internally at present the stock market is not very healthy and is in need of a purge.
My guess is that the selling is not finished. We may bounce here for a day or two, but if the bond market continues to be weak, the Nasdaq Composite (Chart 5) could visit 7500 or so quickly. Selling would likely be contained at that level. Odds are high this is not the start of a bear market for stocks.
Chart 6: Our long term primary trend indicator remains quite positive at present. Market tops are usually made by a rolling-over process rather than a mountain top peak. See my estimates for business cycle – stock market peak below.
Parlor game guesses for cycle peaks
Based on the Fed’s rate hike projections, we’ll reach inversion by February 2019. The Fed has given no signal to indicate they’ll declare a halt to rate hikes which could push the date to later next year. In fact the most recent jobs data makes me think they’ll hit the brakes hard next year.
So, based on an inversion in February 2019 we can make some recession date assumptions based on the past 9 yield curve inversions dating back to 1957:
The shortest lead time from inversion to recession has been 8 months: October 2019. Median lead time from inversion to recession has been 12 months: February 2020.
Longest lead time from inversion to recession has been 20 months: October 2020.
Understand the recession data is based on NBER declared recessions and they date the start of a recession many months in hindsight. But we can make reasonable estimates based on yield curve inversion dates.
The stock market is a forward looking barometer meaning that the markets look ahead into the future. This means the US stock market will peak and begin to rollover before the recession starts.
Based upon data from 1957, the US stock market has peaked on average 5 months before the start of a recession.
Earliest estimated stock market peak is May 2019. Likeliest estimated stock market peak is September 2019. Latest estimated stock market peak is May 2020.
Thanks again to all of you for your trust. As an investment manager, my goal is to avoid the dogmatic approach, be flexible and neutral to market behavior. Any investor who decides to get into an argument and mansplain to the market will emerged bruised and poorer for the experience.
All the best,
We’ve updated our Vegan Growth Portfolio model results with the data through September 30.
Access our VGP Model Data
We’ve updated our Vegan Growth Portfolio model results with the data through September 1. The VGP remains firmly ahead of the S&P 500.
Access our VGP Model Data
We’ve updated our Vegan Growth Portfolio model results with the results through August 1. The VGP remains ahead of the S&P 500.
Access our VGP Model Data
“Nothing but blue skies ahead”
National Trade Council Director Peter Navarro
– June 25th, 2018
July 1, 2018
Summary: Last month I wrote about the Fed and what I expected could happen by the end of 2018 or early next year. My timing last month was too optimistic as things are coming to a head now. I expect the 3rd quarter to be volatile with a downward bias as the Fed and the European Central Banks (ECB) continue to destroy their economies and markets with policy errors.
The world’s stock markets are in the process of crashing. It’s naive to think that the ripple effect will not happen here. Unless the Fed states that they’re going to pause raising interest rates or halting QT (see below), we can expect a market sell-oﬀ in the 15% range. This may be one of the reasons Trump tweeted that he asked the Saudis to increase oil production. There isn’t much inflation in the system right now except for energy prices. By increasing production with the hope of lowering the price of oil, it may be enough reason to for the Fed to halt rate hikes. But we really don’t know what the Fed will do at this point.
At the start of last week, we had three big issues to contend with.
1) The rapid rise of the U.S. Dollar (USD) versus the Chinese Yuan.
China does manipulate their currency against the U.S. as detailed in the chart below. Spikes in the USD/Yuan valuation in recent years have been catalysts for dramatic sell-oﬀs in U.S. stocks. Part of the problem is, in a world starved for short term yield, money is now being converting to USD to buy short term yields. In addition, the effect of QT (See below #3) is also a cause for the increase in demand for USD to buy Treasuries. Regardless of the reason, the devaluation of Chinese Yuan negates much of the tariff risk to China while also having a negative effect on the U.S. economy as U.S. goods become more expensive. Add tariffs to the mix and you can expect a significant slowdown in U.S. growth soon.
The rise of the USD – caused by the Fed raising short term interest rates and investors liquidating short and intermediate term bonds – is causing Emerging Markets (EEM) to crash. The break below the EEM’s primary moving averages occurred at the same time the Fed most recently raised interest rates.
I had been watching the EEM exchange traded fund (ETF) along with its inverse ETF which rises as the EEM declines. We were able to make initial purchases in the $41-$43 zone. See below. I am using the EEV as a hedge against our current stock holdings.
This is how the world’s regional markets are reacting to Fed and ECB policies:
All of these international charts are in the Bear Market zone.
2) The Yield Curve
The Yield Curve continues to decline and, unless the Fed stops raising short term interest rates, it should cross below the 0 threshold which will signal an incoming recession. For more on this click on the following link.
In the chart above, the closer the Yield Curve gets to zero, the more nervous investors will become.
The studies show the recession could be as long as a year or two following an inverted yield curve. But stocks move in anticipation of the future, and the Financial and Industrial stocks in the U.S. are moving into Bear Markets. We don’t need another banking crisis but that exactly what the banks are showing. Just brilliant timing by Congress to eliminate many of the restrictions after the 2008 debacle.
The industrials have to contend with both trade wars and the Fed raising rates. They’re signaling that our present GDP growth is coming to a hard stop unless the Fed stops their behavior.
High Yield Bonds – otherwise known as Junk bonds – can act like an early warning signal as they are a reflection of the risk in credit markets. If Junk bonds are selling oﬀ and Treasury bonds are rallying, that tells us there is trouble brewing as money exits risky credit for safe credit.
High Yield is on the verge of signaling that credit markets could be become increasingly concerned about risk.
3) Quantitative Tightening (QT)
Lastly we have QT. QT is the inverse of QE known as Quantitative Easing. After the collapse in 2008, the Fed and the ECB went on a series of actions (QE) whereby the Fed bought huge amounts of Treasury bonds in an effort to lower interest rates making stocks, treasuries, real estate etc… more attractive. In doing so, they created huge wealth for those who owned risk- oriented assets. However, the downside is that the Fed now owns a huge inventory of bonds and other securities and they have mandated that they must now begin selling oﬀ their inventory to “reduce their balance sheet”.
The liquidation on the open market by the Fed and the ECB is known as QT or Quantitative Tightening. When a central bank sells a security on the open market, the buyer is giving cash to the Fed in exchange for the security. On a mass scale, this reduces the amount of cash or USD in the system.
The primary driving force in the stock market is the ebb and flow of cash in our economy, otherwise known as liquidity. When cash is coming into the system, it makes its way into the markets and drives prices higher. The inverse is also true but we’ve never actually experienced QT before. It could be a disaster on its own. But combined with rising short term interest rates, it could be lethal to the buy-and-hold long term investor.
I’ve shown many charts that show the deterioration of the markets in the U.S. and abroad. In June, the Fed was selling off $30 billion in inventory a month and look at how much damage that created.
Come this month (July), the Fed and the ECB will both be enacting QT. The Fed is scheduled to raise the amount of liquidation from $30 billion a month to $50 billion.
I believe the Fed’s attempt to normalize interest rates is failing. My guess is that, at some point, the Fed will stop but the question is how much further damage will be done before they signal a white ﬂag.
In the past two weeks, I’ve reduced our clients’ risk exposure greatly by adding inverse exchanged traded funds and adding Treasury bonds. Treasury bond prices should rally quite nicely if the Fed continues on its course of action as money moves to safety.
Should there be further weakness in the S&P 500, I’d like to add inverse ETF’s based on the SP 500 as well. A break below 2670 would potentially signal a much further decline ahead.
If you’re a new investor or have capital you’d like to add, this could be an opportunity for you, especially if we have a steep decline and the Fed backs off from rate hikes.
What else could happen? The Chairman of the Fed is Jerome Powell and he will be under intense pressure to stop their present course. Pressure is not surprisingly coming from the White House as well as the Fed is a threat to kill the Presidents economic agenda.
If Powell signals that the Fed is done with raising rates then a move to 3000 in the S&P 500 and a sharp sell oﬀ in long term treasury bonds is not impossible. Stay tuned. But my guess is there will be considerable damage done first.
Powell was appointed by Trump and it’s my understanding he can be fired as well. A firing would be considered a major positive event for risk markets.
Time will tell and this period will pass as well. It’s a time to be very cautious and hedged against risk.
We are positioned to protect our client accounts and beneﬁt if a major decline occurs.
The irony of all of this is I didn’t even mention Trade Wars. But they’re easy to win so it’s all good.
Adapt, Evolve and Prosper
One of the constant questions I ask myself is “Where are we in the business cycle? And, how much time does it have left?” Employment and GDP growth look great now and, as humans with a positive attitude, we’re inclined to think the good news will continue indefinitely. But the problem we have at this late stage in the cycle is the Federal Reserve will soon be raising rates to the point where they will be generating a great deal of pain to the economy. As sure as the sun will rise in the morning, the Fed will push the economy into recession.
The rising stock market acts like a slight of the hand trick distracting us with strong momentum and keeping our attention away from the Treasury bond market. The continuing shrinkage between the yields of the 2 and 10 year Treasury bonds are telling us that we are soon to be at the peak of the business cycle. There is no immediate danger right now as risk assets like stocks, commodities, real estate and crypto’s could have another 6 to 9 months to run higher.
For those of you who are new or have never experienced a cycle peak as an investor, I’m not talking about an ordinary garden-variety market pullback but something on the order of 3x to 4x of the January decline. These cycle peaks are not to be ignored as risk assets are frequently crushed.
I realize this sounds ghoulish and fearful but it’s real. To be frank, from the investment point of view, it’s the necessary transition from an old Bull Market to a new Bull that can last for years. The fulcrum point which could tilt the balance from stocks to bonds will be handled with care as my goal is to continue the growth curve of your accounts by adapting to a changing environment.
As I’ve mentioned in previous letters, I may anticipate a major move in an asset class but I want to see price confirm my suspicion before I act in force. Many an investor goes broke trying to predict what may happen; I prefer to wait until price confirms my thesis.
The best investors in the world have the ability to adapt and conform to whatever environment they face. Passive Indexing, Buy and Hold strategies and those not paying attention are reliant on a rising Bull Market for gains. That’s not the case with RMHI. As an active manager on your behalf, I look at recessions as an opportunity and will reconstruct your investment portfolios to prosper in the coming Bear Market.
A business expansion period can last for most of a decade. In contrast, the cycle peak-to- trough is usually about a year. In other words, risk assets fall a heckuva lot faster than they rise.
There hasn’t been much to say recently as the markets chop up and down with modest net progress. Long term trends for stocks remain positive but there are new signs of life in Treasury Bonds. Everyone, including myself, was looking for higher interest rates in January but I believe that moves to higher rates are over and a reversal to lower rates is emerging. The move to lower rates has likely been magnified by Italy but the closing gap between the 2-year Treasury Bond and the 10-year has been an ongoing trend.
The Nasdaq Composite Index remains the strongest market index as it contains the highest percentage of the best growth companies. In addition, today (June 1) the Nasdaq is breaking out of its May trading range and could be the first of the major indices to reclaim the January peak. So I’m maintaining a higher than average percentage of client assets in Technology as it remains one of the strongest industries (aside from Oil and Gas which of course we don’t touch).
The focus of this client letter is the price behavior in Treasury Bonds and the impact of the world’s Central Banks shifting their policies from pro-growth to restrictive. They’ll likely be very problematic for the economy and stocks in six months to a year.
As the chart below reveals, the world’s central banks are acting in unison. By 2019, the world central banks will be initiating a global slowdown in growth.
Its quite possible that the reversal in Treasury bond prices is a nascent trend that could bring interest rates much lower which in turn would trigger the infamous “Inverted Yield Curve” (IYC). The IYC is a wonkish term to mean that short term interest rates are higher than long term interest rates. IYCs have an impact on consumers since it forces those with adjustable rate mortgages to pay more than fixed rate. The same holds true with lines of credit.
This chart above is a long term chart that does a nice job of revealing the long term trend in long term bonds. The blue line is a 48 month moving average and it conforms to the upward trend. But this month the price of long term Treasury Bonds jumped 2% and is right on the trend line which tells me that all the talk of rising rates is probably wrong.
Plus, given the trends in the Yield Curve which are becoming more ominous, there is a very good chance we’ll begin to buy long term Treasury Bonds in anticipation of a weaker stock market and recession in 2019 and 2020.
It’s a cold truth that every Bull Market will be killed by the Federal Reserve and that includes the Bull Market that exists today, which leads us to this point in time.
Yield Curve Making New Lows
The next chart is a graph of the “Yield Curve”. Its a common occurrence that before recession induced bear markets, the Yield Curve inverts. The Yield Curve has inverted ahead of every recession in the past 40 years. How much money and grief would investors save just by tracking this bit of data?
The Yield Curve is calculated by subtracting the yield of the 2 year Treasury Note from the yield of the 10 year Treasury Bond. Today its 2.83% – 2.40% = .43% as seen in the chart below. Look on the chart above to see how the Yield Curve behaved in 1998-1999 and 2006-2007. By the time the curve turns upward, it’s too late as the damage will be done and the Fed will try to reverse course.
US Monetary Policy is the primary reason we have Bull Markets and Bear Markets for almost every asset class. As the chart above reveals an inverted yield curve has been an excellent forecaster of incoming recessions.
There is a lag time of 6 to 24 months between inversion and recession and we can’t be fooled into thinking “this time it’s different” that a recession won’t occur.
The yield on the 2-year Treasury Note is based on the Federal Funds rate which is controlled by the Federal Reserve. See chart below. The Fed is stair stepping rates higher and has plans to raise rates by .25% two more times this year. Assuming the 10-year Treasury Bond yield stays put, those rate hikes could cut the margin by .50 and down to -.05% (Yield Curve Inversion).
When the yield on the 10-year Treasury and the 2-year T-note are equal or inverted it becomes a giant alarm to run and not walk to the stock market exit. During this period we will sharply reduce are stock holdings to pare down risk. In the past 3 months we’ve head a series of declines in the S&P 500 Index which stopped right on the 200-day moving average (DMA). In a Bull Market we may hedge against the index falling below the 200 DMA but the odds are not very good for major break below.
When monetary policy (meaning the Fed hiking rates) becomes very aggressive, as might be the case in 2019, I would expect a decline back to the 200 DMA followed eventually by a major break below the average and an additional decline of 25% to 40%. This sharp break below the 200 DMA is the trigger point for me to increase exposure to Bear Market related strategies and keep our stock holdings to a minimum.
This next chart below, produced by the St. Louis Federal Reserve, is their own projection of where the Fed Funds rate might be in 2019. They’re projecting the Fed Funds to be a 3.4% late in the year which is well above the current yield of the 10 year Treasury bond of 2.83%.
On the bright side, and there is a bright side at least for the time being: Employment.
Historically, unemployment claims start to rise at least 7 months before a recession and there’s no sign of that now as the chart below illustrates.
Summary: The present data is supportive of a continued market rally in equities and of economic expansion. But looking six months ahead there is concern that we could be dealing with a stock market and business cycle peak. We’ll be prepared to shift from Bull Market positioning to Bear Market strategies in all portfolios. The primary trigger will be a decisive move below the S&P 500 200-day moving average. In the meantime, enjoy the summer and the next leg of the rally.
We’ve updated our Vegan Growth Portfolio model results with the data through June 1. The VGP is up a bit since May 1 and remains well ahead of the S&P 500.
Access our VGP Model Data
We’ve updated our Vegan Growth Portfolio model results with the data through May 1. VGP is still well ahead of the S&P 500.
Access our VGP Model Data
The Post Parabolic Blues
Since the 10% decline in the S&P 500 index in late January I’ve been using my Bull Market playbook to deal with a decline. Technically speaking we are still in a Bull Market but our Bull status is looking more precarious by the day. The Bull Market playbook means I’m looking for a double bottom or retest of the market lows oﬀ the initial sell-oﬀ. Secondly, I’d be looking to buy stocks on signs of a successful retest and rally.
Friday’s 2.19% decline was especially disheartening since it wiped out three days of gains. Stocks had been showing signs of recovery by trying to build a base from which to rally. Previously, markets were appeased by the story that the White House was using the tariﬀ threats as a negotiating tool. But Friday’s news showed that markets are not buying that story any more. This is a dangerous and unpredictable situation that leaves any investor unhedged in stocks vulnerable to policy mistakes and reckless statements from the White House or cabinet.
The second leg down rallies have been relatively weak with reduced volume while declines have been larger in magnitude and increased volume (not good). This reveals that large institutional investors are in a liquidation mode and are using rallies to sell rather than using declines to accumulate. This is Bear Market behavior and is giving me pause to reassess the likelihood of another another significant leg down for stocks and the possibility of a Bear Market.
Perhaps this weakness is the aftermath of the parabolic rise in stocks earlier this year? Plus the extreme readings of investor sentiment? It’s possible, but I’d argue that stocks and bonds are now reacting accordingly to an aggressive Federal Reserve and a much higher than average possibility of policy mistakes from the White House.
Chart 1 above, courtesy of Carl Swenlin of Decisionpoint, shows the importance of the $257 level for the “SPY” aka S&P 500 ETF. Both the 200 day moving average and the underlying trend line from the 2016 rally converge at nearly the same level.
There are also other important issues the world stock markets are contending with:
The global economic recovery is mature and slowing. Worldwide GDP data is showing clear signs of slowing.
Policy Errors: The tax cuts are the personiﬁcation of ﬁscal irresponsibility and there’s no going back.
Trade Wars are “good and easy to win”. Investors aren’t fooled in the least by this rhetoric (see Smoot-Hawley Tariﬀ Act). We’ve never had a President who can just as easily talk up a stock market and talk it down with rhetoric within weeks. This is certainly a market headwind for stocks.
Aggressive Federal Reserve: The “Yield Curve” (shown above in Chart 2) is growing increasingly negative as short term interest rates are rising which will eventually kill the economic expansion. This causes investors to buy long term Treasury bonds. The higher short term yields and lower long term yield ﬂatten the diﬀerence between short and long term rates which reduces the incentive for banks to lend.
The Yield Curve is a simple indicator and one of the most powerful tools to predict markets and the economy. Once the curve drops to .5 its “Goodnight Irene” for stocks and “Good Day Sunshine” for Treasury bonds. This is why we’ve recently added long term Treasury bonds to client portfolios.
If you’d like to learn more about the Yield Curve, there is an array of data from none other than the Federal Reserve:
Our Present Status: A sharp break in the price in Chart 1 below $257 without a rebound implies there is more selling ahead, which could be signiﬁcant. Since my style of investing is based on reacting rather than predicting, I’d look for a $257 break to increase our existing hedges and further reduce stock holdings.
Should the price break below $257 not occur or occur brieﬂy, I’d keep the status quo but expect the bottoming process to take longer than expected. I’d likely prefer to reduce stock holdings in strength until we see a positive change in market behavior.
Treasury bonds: My W.A.G. for Treasury Bonds and the economy is that the Yield Curve inverts in 2019 which will cause a full blown bear market in stocks and bull market in Treasury bonds. T-bonds could rally by more than 20% due to the reduced effect of lowering interest rates in an already low rate environment by the Fed. This could be followed by recession and bear market low by 2020.
Bottom Line: I’m agnostic to market direction as we can generate proﬁts in accounts regardless of market trends. It’s the transition periods which we are possibly in that are tricky to assess. Once a new trend emerges, be it up or down, I’ll adapt and do my best to continue generating proﬁts on your behalf.
We’ve updated our Vegan Growth Portfolio model results with the data through March 30. So far, VGP is well ahead of the S&P 500.
Access our VGP Model Data